Friday, 28 December 2007

From stock to flow- the Enron story repeated

I have a sense of deja-vu. In early 2001, I joined Enron Broadband Services only to leave after a couple of months, shocked at a company culture that had an unhealthy focus on accounting earnings above any other consideration. Three months after my resignation, the company filed for bankruptcy in the largest case of its kind in history. Essentially, the company had booked uncertain future earnings upfront through the use of clever accounting structures, which kept the debt-fuelled growth off-balance sheet. When the uncertainty turned into reality, the whole structure unwound in record time.

Today, it is happening all over again, in what the press have incorrectly dubbed the "sub-prime crisis". Sub-prime loans are only the tip of the iceberg in a business (financial intermediation) that has changed dramatically in the last 15 years. I have been employed in the financial services industry for that time and have been intimately involved in many aspects of that change.

When I started in banking in the early 1990s, the business was all about prudent use of funds which were primarily backed by depositors and a capital base. The philosophy underlying lending was that "we were handling other people's money" and, as such, we had a fiduciary duty to depositors. In addition, any losses would first hit the limited capital base of the bank. Annual profits were predictable, since the prevalent accounting systems would ensure that returns would accrue over time, as the loan portfolio amortised over time. Given capital constraints, new lending was limited to available capacity, which freed up as the loan book matured. In summary, banking was a solid, stable and conservative business in regulated environment (much as Enron's gas pipeline business had once represented).

In the early 1990s, the concept of securitisation was developed. In essence, this entailed the repackaging of loans from bank balance sheets and their subsequent so called "true sale" to investors in exchange for an origination fee, which was booked upfront. Appetite for these securities was supported by institutional investors' demand for fixed income assets, themselves fuelled by favourable economic conditions and the growth of private pension systems. Initially, this business was a small niche which allowed banks to selectively originate loans beyond what their capital base would allow. It also meant that the profit made on a portfolio of loans could be booked upfront on its sale, instead of accruing over time while it matured in the banks' balance sheet.

The traders and investment bankers in banks realised that by changing the banking business from "stock to flow", much larger origination volumes could be underwritten and offloaded ("distributed" in the industry jargon) to investors via securitisation and syndication of loans. Furthermore, and, in order to address investor bases concerned with long tenors and liquidity, special vehicles were created which would issue short term commercial paper to fund long term paper. When traditional investors found themselves full of this asset-backed paper, banks would encourage more aggressive investors (such as hedge funds) by lending them money to buy the instruments they had originated. Huge profits were made as revenues were booked upfront, but the stability of earnings once provided by accrual accounting was foresaken.

As a result, bankers in the late 90s and early 00s were incentivised to focus exclusively on loan quantity and not quality. The mantra over the last couple of years in front office areas has been to originate, originate and originate. Damn credit quality- loans would be offloaded anyway.

Gradually, banks' balance sheets started to accumulate loan inventory that was designed to be temporarily warehoused in anticipation of future sales to investors, as well as loans to investors who would themselves buy the offloaded paper. Also, off-balance sheet liquidity commitments were provided to commercial paper vehicles to guarantee to investors that liquidity would be forthcoming, in the "highly unlikely case of a liquidity crisis occurring". Of course, as these commitments grew, so did the likelihood of such an event occurring.

Then came the summer of 2007. Investors realised that the quality of the underlying loans had become so poor ("ninja loans" or loans to borrowers with no job, no income, and no assets being just one example) that no amount of financial structuring could compensate. Also, asset prices (primarily property) fuelled by this indiscriminate lending had stopped rising. Investors stopped buying new securities and renewing commercial paper, and the "virtuous circle" created by the move from stock to flow turned into a vicious circle.

Banks suddenly found they could no longer sell what they originated. Furthermore, they were stuck with inventory whose poor credit quality they were only too aware of. Market prices plummetted. Their inmediate reaction was to hoard cash in anticipation of future credit problems and obligations to fulfill liquidity commitments provided to commercial paper vehicles.

The consequences thus far have been twofold: first, a liquidity crisis has ensued as banks are forced to fund special purpose vehicles at a time when the interbank market has dried up, and; second, an asset credit quality debacle has occurred as banks are stuck with loan inventory of poor credit quality that they never intended to keep in their balance sheet.

However, this crisis will have longer term consequences. The stock to flow model has been questioned and future profits are likely to be lower than recent ones. Sub-prime loans are only the first in a pyramid of loans that have been granted with little or no regard to willingness or ability to pay. Credit cards, car loans, LBOs and other leveraged loans are likely to come next. The almost limitless and reckless lending which we have seen and which has fuelled much of recent economic growth will dramatically slow down.

A moment of reflection here. Note that poor quality assets are still in the system beyond those reflected in banks, mainly in pension funds, insurance companies, mutual funds and other unsuspecting investors who are investing savings of the general public. Once the music in the game of musical chairs stopped (to paraphrase Citigroup's haplesss former chairman Chuck Prince), the whole house of cards started to collapse.

So, we find ourselves in a position similar to the one experienced in the Enron debacle, except on a systemic scale. Fomer accounting and rewards systems designed to make a sensitive and strategic industry conservative are replaced by a system which incentivises speculation and risk- from stock to flow or from caution to greed.